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Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.

The issues aren’t quite the same as those one faces when considering the deepest aspects of personal faith and religious doctrine, but a “Roth conversion” can pose some difficult issues for investors nonetheless. And we’re going to hear much more about this going forward because of a scheduled change in the law: Unless something unexpected happens in D.C., come 2010 there will no longer be income limits on Roth IRA conversions.

There will be a lot written on the issue of whether one should convert or not, as well as endless articles describing all kinds of “strategies” to potentially leverage the change (some legitimate and others more questionable). For me, three things are important in considering this kind of “conversion”:

1. First and foremost is how strongly you feel about your future income tax rates. If you feel strongly that there is a significant chance your income tax rates will be higher in the future, then having some money in a Roth allows you to “hedge” that risk by paying taxes at today’s rates. Of course, you should note that while the Roth rules currently stipulate that no income taxes are owed on qualified Roth withdrawals, tax laws can change. So while the Roth clearly offers some protection from taxes, it’s not an ironclad guarantee.

2. Second is that you have to recognize that $1 of after-tax wealth is more than $1 of before-tax wealth. What this means is that by converting a $10,000 pre-tax IRA to a $10,000 post-tax Roth IRA, you have effectively put more resources into your IRA account. An example: If your income tax rate is 25%, your $10,000 pre-tax IRA is worth $7,500 of goods and services. Your $10,000 post-tax Roth is worth $10,000 of goods and services. In other words, even if the dollar amounts in traditional and Roth accounts are the same, the Roth gives you an ongoing tax break on “more” wealth. This is why, to properly compare the tax advantages of the two dollar-for-dollar, most quantitative analyses of Roth versus traditional—including Vanguard’s—include a taxable “balancing account” along with the traditional IRA. What you see is that if tax rates don’t change over time, the two IRAs actually offer identical tax benefits per dollar of after-tax IRA wealth. It’s just that you can generally get more after-tax wealth into a Roth. In practice, most people in the real world aren’t going to set up an additional savings account alongside their traditional IRA. So a Roth conversion is a great chance to save more, assuming you can pay the taxes you’ll owe on the conversion from a source other than the converted IRA.

3. A last consideration is how focused you are on spending the money in retirement. A big advantage of a Roth IRA is that you don’t have to take minimum distributions in your lifetime. That means you can keep the money in the “tax-free” wrapper a very long time. This is less of an advantage if you see yourself spending regularly from your IRA in retirement.

Obviously, everyone should consult a tax advisor about his or her own situation. But a Roth conversion in 2010 could offer some significant benefits to a lot of investors. And in all the noise and “strategizing” you’re going to hear in upcoming months, it may be important to stay focused on the basic issues.

Like this:

John Ameriks

John Ameriks oversees the Active Equity Group within Vanguard Equity Investment Group, which manages active quantitative equity fund assets. He is one of Vanguard's thought leaders on retirement issues and has conducted studies on a wide range of personal financial decisions, including saving, portfolio allocation, and retirement income strategies. John came to Vanguard in 2003 from the TIAA-CREF Institute, the research and education arm of TIAA-CREF. He graduated from Stanford University with an A.B. and earned a Ph.D. in economics from Columbia University.

Comments

Anonymous | August 19, 2010 12:33 pm

I’m starting a ROTH IRA conversion. For instance, if I was to convert $2000, what tax % rate is used to figure out how much I would owe in taxes? Vanguard says they can’t help me, because they don’t know how much I would owe in taxes. Perhaps if they told me what tax rate to use then we’d know.
How is Vanguard’s ‘Roth Conversion Calculator’ calculating how much I contribute each month if I’m not entering that information? Considering, I would like to be able to do that. It’s automatically inputting a hypothetical amount that’s not near what I would input.

Anonymous | May 6, 2010 12:53 pm

I recently converted my and my wife’s Vanguard Traditional IRAs to Roth IRAs. We are in the highest marginal income tax bracket and expect to remain so in the future. Given the fact that the highest federal marginal tax rate is due to increase in 2011 and beyond, my question is as follows: I understand that the tax due on conversion to a Roth IRA can be spread over 2011 and 2012. However, would the tax to be paid over the two years be based on the tax liability on the day of conversion, that is at the 35% tax rate when the conversion was made, or would the payments owed in 2011 and 2012 be based on the 39.6% (or higher) marginal rates in those years? Obviously, the answer will determine whether we pay the taxes this year or defer them..

Anonymous | April 23, 2010 3:56 pm

Vanguard’s Roth Conversion Calculator does not seem to take into consideration the future value of the money used for the taxes on the conversion – this makes the benefits appear much greater. Fidelity’s Calculator does take this into consideration by deducting the future value of the tax payment from the Terminal Roth value.

Anonymous | April 9, 2010 1:41 am

I am confused. In your discussion above you ignored the likelihood that the accounts will grow over time. If I defer taxes on contributions made to a traditional IRA today–I will have to pay taxes on the contribution and the earnings when I retire. So, if I put $10K in both a traditional and a Roth IRA today, and say those contributions have doubled when I start taking distributions, I will have to pay taxes on $20K from the traditional, while only paying taxes on the $10K I initially put into the Roth. Thus regardless of the risk of future tax changes, it is certain (unless my IRAs decrease in value) that I will pay, in absolute terms, much more in taxes over my lifetime with a traditional IRA.

Anonymous | March 4, 2010 12:15 pm

I am a teacher and I have a 403(b)(7) retirement account into which I make tax free contributions along with a Roth IRA account. For 2009 I do not qualify to purchase Roths, because my adjusted gross income is too high. I was told I could use after tax money to buy a traditional IRA (nondeductible) and then convert it to a Roth as soon as its established, only having to pay tax on the little money the traditional IRA might make before the conversion. Is this true? Is a 403(b)(7) an IRA? Will I have to pay a percentage of tax on my 403(b)(7)? Any advice would be appreciated?

Anonymous | February 20, 2010 3:39 pm

I have three questions:

1. If I already have an existing ROTH IRA account, can I convert my 403(b) account (fully or partially) to the pre-existing ROTH acct? Or, do I need to set up a new ROTH to receive the converted funds?

2. Is it true that the tax due on the amount converted in 2010 can be deferred and paid in two equal portions in 2011 and 2012?

3. Regardless, does one still need to wait 5 years after conversion to start withdrawing funds from the ROTH account–tax free?

Anonymous | February 15, 2010 3:13 pm

There is some confusion about the $100K income limititation for converting a traditional IRA to a ROTH beyond 2010. Some tax/financial planning web sites indicate that “the special tax provision removing this income limitation applies to conversions done in 2010 only” while other web sites indicate that “starting in 2010, taxpayers with modified AGI of more than $100K will be allowed to convert a traditional IRA to a Roth IRA. This change applies to all years beyond 2010.” IRS Pub 590 (2009) states: “Beginning in 2010, the modified AGI and filing status requirements for converting a traditional IRA to a Roth IRA are eliminated” and “For tax years starting in 2010, the $100,000 modified AGI limit for conversions to Roth IRAs is eliminated.” So, if my AGI exceeds the $100K in 2011, 2012, 2013, etc., will I be able to convert a portion of my traditional IRA balance to a Roth, thus spreading out my tax liability over those several years?

Anonymous | February 13, 2010 1:27 pm

Traditional IRA’s become a problem when one has so much in them that the annually increased RMD triggers a higher tax bracket or tax on social security. My mom is pretty much stuck with this problem because the RMD is already hitting her hard. Older retired people often find themselves in the higher single’s tax bracket due to death & divorce. Its not too late for me. I’m married and have two kids so each year I convert as much to the Roth IRA as possible such that I don’t jump to the next tax bracket. I don’t have to eliminate my tradition IRA, I just have to limit its size so that the RMD doesn’t get too big upon retirement age. Also for Congress, increasing a tax is hard, creating a new tax is harder, but taxing something twice like Roth IRA’s would cause unacceptable political fall out thus unlikely. Congress will tax the least vocal group perhaps dead people (ie. ANY AND ALL THINGS INHERITED).

Anonymous | January 13, 2010 2:52 pm

Since the income limitation on Roth contribution was not lifted in 2010, I was wondering if I could contribute to non-deductible IRA in 2010 and turn around and convert it to Roth in the same year(2010).

Anonymous | January 3, 2010 4:38 pm

Nice succinct article covering the key points. Regarding future tax laws, I agree with the vast majority of published articles that express the expectation that the Roth is likely to remain (income) tax free. Far more likely than a change to that, in my opinion, is increased taxation of consumption in the form of sales taxes, gasoline, tobacco, and alcohol excise taxes, and indirect taxation by including Roth income in determining taxability of other income (such as Social Security benefits) as the interest on municpal bonds is now. These are very real risks no doubt but need to be considered in the context of our current historically low marginal tax rates.

As for the compounding issue, you still benefit from compounding after conversion. If you use “outside” money to pay the taxes, you are effectively increasing your retirement savings which is especially valuable if you have maxed out your tax-deferred options such as 401(k) and deductible IRA plans. Basically you want to convert just enough to pay taxes at a rate that you are confident is lower than the rate you will be paying when you take the money out. (Yes, it’s break-even if you’ll pay at the same rate later but I think you should think of that as a safety cushion.) There is no hurry — no need to convert all of your pre-tax IRA money at once (you could convert monthly or quarterly or wait a few years before starting) or ever (certainly don’t deplete your other assets too much).

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.